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Recovery with Applications to Forecasting Equity Disaster Probability and Testing the Spanning Hypothesis in the Treasury Market

Published online by Cambridge University Press:  18 July 2022

Gurdip Bakshi Open the ORCID record for Gurdip Bakshi [Opens in a new window] ,
Xiaohui Gao  and
Jinming Xue
Gurdip Bakshi*
Affiliation:
Temple University Fox School of Business
Xiaohui Gao
Affiliation:
Temple University Fox School of Business xiaohui.gao.bakshi@temple.edu
Jinming Xue
Affiliation:
Southern Methodist University Cox School of Business jinmingx@mail.smu.edu
*
gurdip.bakshi@temple.edu (corresponding author)
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Abstract

We investigate the implications of recovering real-world conditional expectation of return functions using options on the S&P 500 index and Treasury bond futures. First, we construct estimates of the probability of disasters, defined as higher than 6%, 5%, or 4% equity market declines over option expiration cycles. This measure of disaster probability forecasts realized disasters. Second, we employ options on the futures of the 10- and 30-year Treasury bonds to construct estimates for the expected return of bond futures. These measures display forecasting ability for subsequent futures returns beyond the level, slope, and curvature variables extracted from the yield curve.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 4 , June 2023 , pp. 1808 - 1842
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

We are extremely grateful for the feedback of the referee and Jennifer Conrad (the editor). Earlier versions were presented at the Chinese University of Hong Kong, the University of Massachusetts–Amherst, the University of Maryland, the University of North Carolina–Chapel Hill, Temple University, the University of Wisconsin–Madison, and the Midwest Finance Association meetings (San Antonio). It was a pleasure to address the comments of John Campbell, Fousseni Chabi-Yo, Yannick Dillschneider, Jens Jackwerth, Chris Jones (a discussant), Johnathan Loudis, Raimond Maurer, and Ngoc-Khanh Tran. We sincerely appreciate the comments of David Brown, Vincent Campasano, Jay Cao, Peter Carr, Ric Colacito, Robert Connolly, John Crosby, Ian Dew-Becker, Robert Engle, Bjorn Eraker, Steve Heston, Nikunj Kapadia, Hossein Kazemi, Matthew Linn, Mark Loewenstein, Dilip Madan, Sanjay Nawalkha, Daniela Osterrieder, Erwan Quintin, Alberto Rossi, Oleg Rytchkov, Shrihari Santosh, Pavel Savor, Sang Byung Seo, Ivan Shaliastovich, Xiaoxiao Tang, and Liuren Wu. Wei Zhou suggested improvements to the proofs. All computer codes are available from any of the authors.

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